SM 300

Engineering Economics
 Basic Concepts
What is Economics?
Economics is the study of how societies use scarce
resources to produce valuable commodities and
distribute them among different people.
This definition uses the idea of…
Scarcity –
Suppose infinite quantities of every good/service could be
produced or human desires were fully satisfied, what
would be the consequence?
Will you be interested in studying / earning any income???
Will businesses need to think about suitable pay-packages for
hiring???
Will anybody care for distribution of income among people???
 Free Good vs Economic Good
Free Good = Good that is available in abundance. Eg
---- Air
---- Sand in dessert/NITK beach
How much do you pay to get these or what is the price of the free
good?
Economic Good = Good that is scarce or limited in supply
….. compared to the unlimited WANTS
Thus,
Given unlimited wants, it is important that an economy
makes the best use of its limited (or scare) resources
This leads us to the notion of Efficiency
Efficiency = The most effective use of a society’s resources
in satisfying people’s wants and needs
 Science , Engineering and Engineering Economics
Science and the role of the Scientist
Science = Knowledge about or study of the natural world based on
facts learned through experiments and observation
The role of the scientist is to add to humankind’s accumulated body
of systematic knowledge and to discover universal laws of
behavior. Eg of science…
Law of Conservation of Energy (Physics and Chemistry)
Engineering and the role of the Engineer
Engineering = The profession in which knowledge of mathematical
and natural sciences gained by study, experience, and practice is
applied with judgment to develop ways to utilize economically the
materials and forces of nature for the benefit of mankind.
Role of engineer is to apply the knowledge of science to particular
situations to produce products and services, mostly to satisfy
human wants. Eg of Engineering
Fan to convert Electrical Energy into Mechanical Energy
 Bi-Environmental Nature of Engineering

Engineers have to face 2 important interconnected environments–

Physical and Economic
Their knowledge of physical laws  Produce products and services
Worth of these products/services depends on their utility measured
in economic terms
 Bi-Environmental Nature of Engineering (Contd.)
Laws of the physical environment are more narrower and
more certain… hence experiments can be used to control
certain factors and arrive at similar results….
However, economic environment is uncertain since it
depends on the behavior/actions of people acting singly
and/or collectively

The usual function of engineering is to manipulate

elements of physical environment to create value in the
economic environment…
However sometimes engineers have a tendency to
disregard economic feasibility… and do not like actions
based on estimates and judgment
 Example
(Source: http://www.startupover.com/en/20-million-burning-smell-like-just-ask-digiscents/)
A particular idea, which raised $20
million in funding (during 1999-2001) to
create a product that was never released
on the market…
iSmell by Digiscents
It had a sort of “database of smells,” which would collect a certain
number of smells, and then producing a device to connect to the
PC, which would react to impulses from digital files loaded on web
pages or emails, releasing the most suitable fragrance to what you
were viewing on the PC.
The missing link was market survey… At that time it did not meet any
need from the public and could not create one.
In March 2013, however, a group of Japanese researchers unveiled a
prototype for a “smelling screen“: a screen that emits scents….
2017: The NeOse smell recorder could help your fridge detect
spoiled food (Source: https://www.theverge.com/2017/1/3/14160968/aryballe-neose-artificial-nose-scent-detector-ces-2017)
 Engineering Economy or Engineering Economics
The objective of engineering economy is to prepare engineers
to cope effectively with the bi-environmental nature of
engineering application

Engineering Economy- involves the systematic evaluation of the

economic merits of proposed solutions to engineering
problems… To be economically acceptable (i.e. affordable),
solutions to engineering problems must demonstrate a
positive balance of long-term benefits over long-term costs,
and they must also
• Promote the well-being and survival of an organization
• Embody creative and innovative technology and ideas
• Permit identification and scrutiny of their estimated outcomes
 Engineering Economy and the Design Process
The Engineering Design Process

An engineering
economy study is
accomplished using
structured procedure
and mathematical
modeling techniques.

The economic results

are then used in a
decision situation that
normally includes
other engineering
knowledge and input.
 SM 300

Engineering Economics
 Engineering Economy and the Design Process
The Engineering Design Process

An engineering
economy study is
accomplished using
structured procedure
and mathematical
modeling techniques.

The economic results

are then used in a
decision situation that
normally includes
other engineering
knowledge and input.
 Engineering Economy and the Design Process (Contd.)
The General Relationship between the
Engg. Economic Analysis Procedure and Engineering Design Process

Note: There are feedback loops within the procedure

 Seven Principles of Engineering Economy
i. Develop the alternatives
ii. Focus on the differences
iii. Use a consistent viewpoint
iv. Use a common unit of measure
v. Consider all relevant criteria
vi. Make uncertainty explicit
vii. Revisit your decisions
 Seven Principles of Engineering Economy (Contd.)
Principle 1: Develop the alternatives
The choice (decision) is among alternatives. The
alternatives need to be identified and then defined for
subsequent analysis.
Why is this step important?
It can impact the quality of decision… engineers and managers
should pay high priority on this responsibility.
Creativity and innovation are essential to the process.
Doing nothing or Status quo can also be a feasible solution in some
decision situation… it should also be considered… but not at the
cost of innovative or necessary change.
For eg. Different sources of electricity generation can be using coal,
water, solar, wind, tide.
 Seven Principles of Engineering Economy (Contd.)
Principle 2: Focus on the Differences
Only the differences in expected future outcomes among
the alternatives are relevant to their comparison and
should be considered in the decision.
What will happen if all the outcomes of the different feasible
alternatives were exactly the same?
No need for comparison… we would be indifferent among the
alternatives… random selection can be used to choose
Hence, outcomes common to all alternatives can be disregarded in
the comparison and decision. Eg.
Decision regarding office space… if Rent/Price for office space in two
location is the same then one needs to focus on other factors like
parking, electric and water connectivity etc.
 Seven Principles of Engineering Economy (Contd.)
Principle 3: Use a Consistent Viewpoint
The prospective outcomes of the alternatives, economic
and other, should be consistently developed from a
defined viewpoint (perspective).
The perspective of the decision maker is often that of the owners of
the firm….
Yet it is important that the viewpoint for the particular decision be
first defined and then used consistently in the description,
analysis, and comparison of alternatives… Eg..
Location of the factory for a manufacturing company…owner’s
viewpoint.
Moving from manual operations to automated or computer assisted
operations in a company…. employees’ viewpoint.
Construction of a Dam or Nuclear Power facility…. public’s viewpoint
 Seven Principles of Engineering Economy (Contd.)
Principle 4: Use a Common Unit of Measure
Using a common unit of measurement to enumerate as
many of the prospective outcomes as possible will
simplify the analysis of the alternatives.
For economic consequences, a monetary unit such as Dollars or
Rupees is the common measure.
One should try to translate other outcomes (which do not initially
appear to be economic) into the monetary unit… Eg.
Decision on whether to outsource production of a particular
component that is required for the product… there may be several
risks involved… which needs to be converted to monetary terms.
It is almost impossible to convert some outcomes to monetary terms
before the decision is taken… eg. Employee satisfaction .. In these
cases describe the consequences explicitly for decision maker.
 SM 300

Engineering Economics
 Seven Principles of Engineering Economy
i. Develop the alternatives
ii. Focus on the differences
iii. Use a consistent viewpoint
iv. Use a common unit of measure
v. Consider all relevant criteria
vi. Make uncertainty explicit
vii. Revisit your decisions
 Seven Principles of Engineering Economy (Contd.)
Principle 5: Consider All Relevant Criteria
Selection of a preferred alternative (decision making)
requires the use of a criterion (or several criteria).
The decision process should consider both the outcomes
enumerated in the monetary unit and those expressed in
some other unit of measurement or made explicit in a
descriptive manner.
Normally an alternative that will best serve the long-term interests of
the owners of the organization is selected.
In Engineering Economic Analysis, the primary criterion relates to
the long-term financial interests of the owners… based on the
assumption that available capital will be allocated to provide
maximum monetary returns to the owners….
However, there can be other objectives as well… growth, satisfaction
 Seven Principles of Engineering Economy (Contd.)
Principle 6: Make Risk and Uncertainty Explicit
Risk and uncertainty are inherent in estimating the future
outcomes of the alternatives and should be recognized in
their analysis and comparison.
Analysis of the alternatives involves projecting or estimating the
future consequences associated with each of them…
However, the magnitude and the impact of future outcomes of any
course of action are uncertain.
Even if one chooses status quo the probability is high that today’s
estimate of future cash receipts and expenses will not be what
eventually occurs tomorrow. Eg….
Deciding whether to investment more on R&D when you already
have a patent for a product/process.
 Seven Principles of Engineering Economy (Contd.)
The Tale of two Drugs:
Zantac and Tagamet

In 1977, SmithKline received a patent for its revolutionary anti-ulcer

drug, Tagamet (cimetidine), which gave it the monopoly rights to
sell Tagamet in the United States. It was sold as a prescription
drug…
This forced the (then) rival company Glaxo to design around the
patent leading to the development of anti-ulcer drug Zantac
(ranitidine), which was introduced to the market in July 1983…
soon Zantac became world’s best-selling drug.
Following this there was a full-fledged product competition war
between the two till year 2000, when Glaxo Wellcome merged
with SmithKline Beecham to form the corporation GlaxoSmithKline
(GSK).
 Seven Principles of Engineering Economy (Contd.)
Principle 7: Revisit Your Decisions
Improved decision making results from an adaptive
process…
To the extent practicable, the initial projected outcomes of
the selected alternative should be subsequently
compared with actual results achieved.
Learning from and adapting based on our experience are
essential and are indicators of a good organization.
Too often no feedback to the decision-making process
occurs… which is in fact important for future decision
making on related problems.
 Engineering Economic Process… with Application
Your friend bought an apartment building for $100,000. She spent
$10,000 of her own money, got a mortgage for the remaining
$90,000. Annual mortgage payment to the bank is $10,500.
Expected annual maintenance of the apartment building is
$15,000. She can rent out the 4 apartments (two bedrooms each)
in the building, at $360 per month. [Assume she was working after 12th
standard till last month when she bought an apartment]
Q1. Does your friend have a problem?
Ans:
Apply Step 1 of EE Process: Problem recognition, definition, and
evaluation
• Money Spent by Your Friend annually= $10,500 + $15,000 =
$25,500
• Money Earned by her annually = 4 × 12 × $360 = $17,280
• Net cash flow = $17,280 – $25,500 = –$8,220.
• Seems she is not doing so well… What can she do next?
Engineering Economic Process… with Application(contd.)
Apply Step 2 of EE Process: Development of Alternatives…
Generally, this involves two primary actions:
(1) Searching for Potential Alternatives and
(2) Screening them to select a smaller group of feasible alternatives
for detailed analysis
Superior Alternatives can be searched by applying Principle 1… Use
creativity to Develop Alternatives
Most of the Ideas require investment of money, and only a few of all
feasible ideas can be developed… due to lack of time, knowledge,
or resources….
Use techniques to develop investment alternatives by removing
some of the barriers to creative thinking-
(1) Classical Brainstorming- Based on the principles of Deferment of
judgment and Quantity breeds Quality
Engineering Economic Process… with Application(contd.)
Steps in Brainstorming (A. F. Osborn)
(i) Preparation- Select participants (4-7) and circulate preliminary
problem statement
(ii) Brainstorming- Warm up session with simple unrelated problem
 the relevant problem with 4 rules presented--- Rules are-
1. Criticism ruled out
2. Freewheeling is welcomed
3. Quantity is wanted
4. Combination and improvement are sought
(iii) Evaluation- Ideas are evaluated relative to the problem

(2) Nominal Group Technique (NGT)- Structured group meeting (5-10

people) to incorporate individual ideas and judgments into group
consensus.
Engineering Economic Process… with Application(contd.)
The Basic Format of Nominal Group Technique (NGT)-
(i) Individual silent generation of ideas
(ii) Individual round-robin feedback and recording of ideas
(iii) Group clarification of each idea
(iv) Individual voting and ranking to prioritize ideas
(v) Discussion of group consensus results

Q2. What are the alternatives available to your friend?

 SM 300

Engineering Economics
Engineering Economic Process… with Application(contd.)
Q2. What are the alternatives available to your friend?
Ans:
(A) Raise the rent.
(B) Lower the maintenance expenses.
(C) Sell the apartment building.
(D) Abandon the building.
Engineering Economic Process… with Application(contd.)
Apply Step 3 of EE: Develop Prospective Outcomes
Incorporates Principle 2 (Focus on Differences), Principle 3 (Use a
Consistent Viewpoint) and Principle 4 (Common Unit of Measure)
It also uses the Basic Cash-Flow Approach employed in EE…
Represents Economic Effects of an alternative in terms of money
spent and received

In the Case of Your Friend-

(A) Raise the rent…. How much??
To cover the monthly expense of $25,500/12 = $2,125, the rent has
to be $2,125/4 = $531.25 (for each of the 4 apartments)
i.e. an Increase of $(531.25 – 360) = $171.25 which is
171.25/360 * 100 = 47.6% increase!
Engineering Economic Process… with Application(contd.)
Apply Step 3 of EE: Develop Prospective Outcomes (contd.)
(B) Lower the maintenance expenses… How much??
Lower the monthly expenses such that the expenses are covered by
the monthly revenue of $1,440
Present monthly expenditure = $25,500/12 = $2,125
Since annual mortgage payment ($10,500) cannot be reduced…
hence only option is to bring down the monthly maintenance cost
of building to a value $C such that
($10,500/12) + $C = $1,440
i.e. the monthly maintenance cost should be at ($1,440 –
$10,500/12) = $565 rather than the present $1500/12 = $1250
This amounts to (565-1250)/1250*100 = 54.8% drop in maintenance
cost.
Engineering Economic Process… with Application(contd.)
Apply Step 3 of EE: Develop Prospective Outcomes (contd.)
(C) Sell the Apartment Building… Approximate selling price??
The apartment building should be sold at a selling price which
recovers the original $10,000 investment + the amount that she is
losing every month on this venture during the time it is owned…
i.e. $8220/12 = $685 per month
(D) Abandon the Building… Can this option be bad for your friend??
If your friend walks away from the venture, the bank will most
probably take possession through foreclosure and also try to
collect some penalty from her…. Her credit rating would also fall….
i.e. A Very Bad Option!!!
Engineering Economic Process… with Application(contd.)
Apply Step 4 of EE: Select a Decision Criteria
For this step one should incorporate Principle 3 (Use a Consistent
Viewpoint) and Principle 5 (consider all relevant criteria)
For your friend the criterion to discriminate among the alternatives
could be “minimize the expected loss of money”
Another criterion could be “credit worthiness”

Apply Step 5 of EE: Analysis and Comparison of Alternatives

For this step Principle 2 (Focus on differences) and Principle 6 (Make
Risk and Uncertainties Explicit) are important
If your friend considers both “minimization of cost” and “credit
worthiness” then Option D (Abandon the building) is immediately
ruled out.
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Engineering Economics
Engineering Economic Process… with Application(contd.)
Apply Step 5 of EE: Analysis and Comparison of Alternatives (Contd.)
Option C (Sell the Apartment Building) may also affect your friend’s
credit rating. Further, there is uncertainty regarding complete
recovery of investments (or costs)… people may not be willing to
pay higher price than what she had bought it for…
Thus, options A (Increase Rent) and B (Reduce Maintenance Costs)
may be the only alternatives worth pursuing..
What if a new Directive is expected in near future from the local
government that each apartment building should compulsorily
have an appropriate security system installed and maintained by
the owner?
This unexpected directive (i.e. future uncertainty)  your friend
cannot reduce maintenance costs much…  Only Option A
(Increase rent) may become relevant then.
Engineering Economic Process… with Application(contd.)
Apply Step 6 of EE: Selection of Preferred Alternative
If the above directive from local government is impending then the
preferred alternative for your friend would be Option A (Increase
Rent)…
Your friend may try to do market research of comparable housing in
the area… or
Maybe a fresh coat of paint and new carpeting would make the
apartments more appealing to prospective renters...

Then rent can probably be raised to cover all the cost and with 100%
occupancy of the four apartments.
Engineering Economic Process… with Application(contd.)
Apply Step 7 of EE: Performance Monitoring and Post evaluation of
Results
For this step Principle 7 (Revisit your Decisions) is relevant.
Your friend decides to offer the apartment at higher rent… Three
apartments are occupied by families… However she is not getting
tenant for fourth one… she has to search for solution for this….
Maybe she can rent the 4th apartment to two students on price-
sharing basis that can cover the remaining costs.

Thus, the 7 steps of the Engineering Economic Process has been

applied to solve a general problem.
 An important concept in Economics- Efficiency
Objective of Engineering is to get the greatest end result per unit of
resource expenditure…. Essentially a physical process in which the
objective is the maximization of physical efficiency (or
Engineering Efficiency) i.e.

If interpreted broadly enough, physical efficiency is the measure of

the success of engineering activity in the physical environment
with respect to a particular input
Eg. Efficiency of an engine = The amount of usable energy produced
by the engine/ Amount of energy in the fuel burned by engine
The loss may be due to friction, heat loss, other unavoidable waste…
Steam engine is 40% efficient  40% of energy in the fuel that is
burned in the boiler is converted into work that is done by the
engine, while the other 60 percent is lost.
When such physical units are involved, efficiency will always be less
than unity, or less than 100%
 Concepts of Efficiency (contd.)
Technical Efficiency
It is related to the physical amount of all factors used in the process
of producing some product.
A particular method of producing a given level of o/p is technically
efficient if there are no other ways of producing the o/p that use
less of at least one i/p while not using more of any others. Eg.
Suppose a firm is using technology (T1) to produce current level of
o/p using 100 units of labour and 50 units of capital…
However, there exists a technology (T2) where same amount of o/p
can be produced using only 90 units of labour and 50 units of
capital  Currently firm is technically inefficient … wasting 10
labour units
Thus technical efficiency is about getting most o/p from any given set
of i/ps OR equivalently,
Producing given o/p level using the least amount of physical i/ps.
 Concepts of Efficiency (contd.)
Economic Efficiency is related to the (economic) value (rather than
physical amounts) of all inputs used in producing a given output.
Expressed in terms of economic units of output divided by economic
units of input, each expressed in terms of a medium of exchange
such as money i.e.

The production of a given output is economically efficient if there are

no other ways of producing the output that use a smaller total
value of inputs…
Economic Efficiencies can exceed 100% and must do so for economic
ventures to be successful….
The most difficult part of determining economic efficiency is
accounting for all the factors which might be considered benefits
or costs of a particular project, and converting these benefits or
costs into a monetary equivalent.
 Concepts of Efficiency (contd.)
Vilfredo Pareto (1848-1923), Italian Economist

Pareto’s definition of Economic Efficiency

Pareto Efficiency
All allocation of resources is Pareto Efficient if it is not possible
(through further reallocations) to make one person better-off
without making someone else worse-off.
Given an initial allocation of goods among a set of individuals, a
change to a different allocation that makes at least one individual
better off without making any other individual worse off is called a
Pareto Improvement.
An allocation is defined as "Pareto efficient" or "Pareto optimal"
when no further Pareto improvements can be made.
The Production Possibility Frontier (PPF) is an example of Pareto
Efficient Frontier.
 The Production Possibility Frontier
The Production Possibility Frontier or Production Possibility Curve =
A graph that shows the combinations of output that the economy
can possibly produce given the available factors of production and
the available production technology
The economy can
produce any combination
on or inside the frontier.
Points outside the frontier
are not feasible given the
economy’s resources.

Can you identify the points

which are efficient and
inefficient?
 SM 300

Engineering Economics
 Concepts of Efficiency (contd.)
How is Physical Efficiency related to Economic Efficiency? Eg.
Suppose a coal based power plant has the physical efficiency of only
36% i.e. Only 36% of the total energy (say in British Thermal Unit
or Btu) produced by the raw material coal is usable to generate
electricity.
However the goods and services produced using this electrical
energy are worth $14.65 per million Btu and the cost of the input
coal used for producing this energy is $1.80 per million Btu, then
economic efficiency…

Thus, a power plant may be profitable in economic terms even

though its physical efficiency in converting units of energy in coal
to electrical energy may be relatively low.
 Concepts of Efficiency (contd.)
In the final evaluation of most ventures, Economic Efficiency takes
precedence over Physical Efficiency because….
Projects cannot be approved, regardless of their physical efficiency, if
• there is no conceived demand for them among the public
• they are economically infeasible, or
• if they do not appropriately allocate the resources that they
require
Eg…. Proposal to purify water needed by a large city by boiling it and
collecting again through condensation…
This proposal may be feasible for science laboratories in schools…
but for the large scale application it may at present be too costly…
 Concept of Value and Utility
In economics, Value = A measure of the worth that a person ascribes
to a good or a service
Thus, the value of an object is inherent not in the object but in the
regard that a person has for it….
Value may not be equal to Cost or Price of the object…
There may be little or no relation between the value a person
ascribes to an article and cost of providing it or the price that is
asked for it… Eg.
Value of a cricket bat…
For a cricket fan and for a cricket hater;
For the company that manufactures that cricket bat and for the
shopkeeper who sells the cricket bat.
Utility = A measure of the power of a good or a service to satisfy
human wants
 Concept of Value and Utility (Contd.)
According to Adam Smith “Value” itself has two meanings- “Value in
Use” (or utility) and “Value in Exchange” (the power of a
commodity to purchase other goods)
When “value in exchange” is expressed in terms of money, it may be
called as price
In ordinary circumstances, a large variety of goods and services is
available to an individual…
The utility of these for the individuals in their mind may range from
abhorrence, through indifference, to intense desire…
The evaluation of utility of various items is not ordinarily constant
but may be expected to change with time.
These same goods and services may also be desired by others, who
may ascribe to them very different utilities.
 Concept of Utility (contd.)
The possibility for exchange exists when each of two persons
possesses utilities desired by the other. Eg.
Cricket lover having a Chess board in his/her possession willing to exchange
it with the Cricket bat that a Chess lover may have in his/her possession.
Utilities can be created by changing the physical environment… Eg.
For individuals…
Apply Heat

Batter Increased Utility in the form of Dosa (Can

satisfy Hunger)
For industries…
Apply Heat and Force

Copper Copper Wound Transformer

Purpose of most engineering effort = How physical factors can be altered to create
the most utility at the least cost in terms of the utilities that must be given up.
 Paradox of Value or Diamond-Water Paradox

When Adam Smith lectured at the University of Glasgow in the

1760s, he introduced the study of demand by posing a puzzle.
Common sense, he said, suggests that the price of a commodity
must somehow depend on what that good is worth to consumers—
on the amount of utility that the commodity offers.
Yet, Smith pointed out, some cases suggest that a good’s utility may
have little influence on its price.
Smith cited diamonds and water as examples.
He noted that water has enormous value to most consumers;
indeed, its availability can be a matter of life and death. Yet water
often sells at a very low price or is even free of charge, whereas
diamonds sell for very high prices even though few people would
consider them necessities.
Marginal Analysis can give some insights into this
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Engineering Economics
 Classification of Goods and Their Utilities
As per economists, based on who is buyer/receiver of the
goods/services, the goods can be classified as:
1. Consumer Goods
They are the goods and services that directly satisfy human wants. Eg
House, shoes, television, health services, orchestra etc.

The Utility ascribed to such goods is a result of subjective mental

process…

Sellers of consumer goods find

emotional appeals more effective
than factual information.
 Classification of Goods and Their Utilities (Contd.)
2. Producer Goods
They are the goods and services that satisfy human wants indirectly
as part of the production or construction process.
In the long run, they are used as a means to an end- that of
producing goods and services for human consumption. Eg.
Machine tools, bulldozers, cranes, ships, and other transport and
services that are used by companies and industries.
 Classification of Goods and Their Utilities (Contd.)
2. Producer Goods (contd.)
Utility of Producer Goods , usually is considered objectively…
Suppose the Electric Lights industry in India feels that production of
1.5 million LED bulbs per week will fulfill the desire of various end
users to have illumination …
Then the utility of the raw materials like glass and diodes that go into
making of the bulb can be predict with much more accuracy….
In general,
while the determination of the kinds and amount of consumer goods
needed at any given time depends on subjective human
considerations….
the problems associated with their production are quite objective by
comparison.
 Consumer Behavior
(Source: Pindyck and Rubinfeld, Microeconomics)
Theory of Consumer Behavior deals with the explanation of how
consumers allocate incomes to the purchase of different goods
and services.
Consumer Behavior can be understood in three distinct steps
1. Consumer preferences
Find a practical way to describe the reasons people might prefer one
good to another.
2. Budget constraints
Take into account the fact that consumers have limited incomes
which restrict the quantities of goods they can buy.
3. Consumer choices
Given their preferences and limited incomes, consumers choose to
buy combinations of goods that maximize their satisfaction.
 Consumer Preferences
Concept of Market Basket or Market Bundle:
It is a list with specific quantities of one or more goods. Eg.

To explain the theory of consumer behavior, we have to ask whether

consumers prefer one market basket to another.
 Consumer Preferences (contd.)
Basic Assumptions about Preferences: These hold true for most
people in most situations… thus imposing degree of Rationality
and Reasonableness on Consumer preferences for analysis
1. Completeness
• Preferences are assumed to be complete… Consumers can
compare and rank all possible baskets.
• Thus, given 2 market baskets A and B, a consumer will
– Prefer A to B or
– Prefer B to A or
– Be indifferent between the two, where indifferent  the
person will be equally satisfied with either basket.
When can the above assumption fail?
Note: These preferences ignore costs. A consumer might prefer
pizza to burger but buy burger because it is cheaper.
 Consumer Preferences (contd.)
Basic Assumptions about Preferences (contd.)
2. Transitivity
• Preferences are assumed to be transitive
• If consumer has preference such that
Basket A > Basket B > Basket C (where > means “preferred over”)
Basket A > Basket C [i.e. No Cycles in preferences]
Transitivity assumption is necessary for consumer consistency

3. More is Better than Less

Goods are assumed to be desirable i.e. to be “Good”
Hence, consumers always prefer more of any good to less
Also it is assumed that consumers are never satisfied… more is
always better even if a little better.
Thus “bads” like pollution are ignored in this analysis.
 Consumer Preferences (contd.)
Indifference Curves
• It is used to show a consumer’s preferences graphically
Indifference Curve represents all combinations of market baskets
that provide a consumer with the same level of satisfaction
Describing Individual
Preferences
Since more is preferred to less,
comparison of baskets in the
shaded areas easy… Basket A is
clearly preferred to basket G,
while E is clearly preferred to A.

However, A cannot be compared

with B, D, or H without additional
information.
 Consumer Preferences (contd.)
Indifference Curves (Contd.)
• Additional information about the preferences is obtained when an
indifference curve is plotted… Eg. U1 in the below figure
An Indifference Curve
What can you say more about
preferences between various
baskets?
 Consumer Preferences (contd.)
Indifference Curves (Contd.)
• Additional information about the preferences is obtained when an
indifference curve is plotted… Eg. U1 in the below figure
An Indifference Curve
What can you say more about
preferences between various
baskets?

It is now clear that B, A and D

are on same indifference curve
 Indifference between the
combinations…

However, this consumer

prefers A to both H and G since
U1 is above those points.
 Consumer Preferences (contd.)
Indifference Maps
Graph containing a set of indifference curves showing the market
baskets among which a consumer is indifferent
An Indifference Map
Figure shows three
indifference curves that
form part of an indifference
map.

The entire map includes an

infinite number of such
curves.
 SM 300

Engineering Economics
 Consumer Preferences Properties
Indifference Curves in an Indifference Map Cannot Intersect

This is Not Possible… Why?

Here, consumer is
indifferent between A, B
and D baskets…

However, as per the

assumptions, B should be
preferred over D since it has
more of both Food and
Clothing  Violation of
assumption… therefore not
possible
 Consumer Preferences Properties (contd.)
Indifference Curves Are Downward Sloping
• This follows from the assumption that more of the good is always
better than the less…
• If indifference curve sloped upwards… then there would exist a
point on the curve where the consumer would be indifferent
between the baskets even if he/she is getting more of both the
goods.

VS
 Consumer Preferences Properties (contd.)
Indifference Curves Are Convex
• This is another important assumption regarding Indifference
Curves for “Goods”… Is it meaningful?
• Yes… As more and more of one good is consumer, we can expect
the consumer will prefer to give up fewer and fewer units of a
second good to get additional units of the first one!
 Consumers generally prefer balanced market baskets

Increased
Increased
Preference
Preference
VS

Note: For analysis “Bads” can be redefined into “Goods” Eg. “No Smog” is “good”
 Consumer Preferences (contd.)
Marginal Rate of Substitution (MRS)
= Maximum amount of a good that a consumer is willing to give up in
order to obtain one additional unit of another good.
The magnitude of the slope of an
indifference curve measures the
consumer’s marginal rate of substitution
(MRS) between two goods.

Here, the MRS between clothing (C) and

food (F) falls from 6 (between A and B)
to 4 (between B and D) to 2 (between D
and E) to 1 (between E and G).

When the MRS diminishes along an

indifference curve, the curve is convex.
 Consumer Preferences (contd.)
• The shape of an indifference curve describes the willingness of a
consumer to substitute one good for another.
• An indifference curve with a different shape implies a different
willingness to substitute.
Perfect Substitutes:
Two goods for which the marginal rate of substitution of one for the
other is a constant… Eg.
Blue ink pen and Dark-blue ink pen for writing notes in class
Perfect Complements:
Two goods for which the Marginal Rate of Substitution is zero or
infinite. Eg.
Left shoe and Right shoe
How will the Indifference Curves be in above two cases?
 SM 300

Engineering Economics
 Consumer Preferences (contd.)

Note: The slope of the indifference curves need not be 1 for perfect
substitutes. Eg. If one believes that one 16-megabyte memory chip is
equivalent to two 8-megabyte chips because both combinations have
the same memory capacity
 the slope of the indifference curve will be 2 (16-Mbyte chip is on y-axis)
 Consumer Preferences Eg.- Designing a New Automobile
Suppose you work for a leading car company and have to help them plan
new models to introduce.
To find out how much people are willing to pay for various attributes, the
company undertakes a survey… The following are the preference curves
for two different market segments (i.e. groups of consumers), say A & B.

Which attribute will you focus on for designing the new car models for
each of the Market Segments?
 Consumer Preferences Eg.- Designing a New Automobile
Ans:

For market segment A, as compared to market segment B, attribute

“Acceleration” is more important since the market segment is
willing to give up more of space to get little more of acceleration.
Note: The scale and units of the two attributes are the same for the
indifference maps of Market Segments A & B.
 Utility Functions and Indifference Curves
• Consumer theory relies on the assumption that consumers can
provide only relative rankings of market baskets.
• Yet, it is often useful to assign numerical values to individual
baskets.
• In the language of economics, the concept of utility refers to the
numerical score representing the satisfaction that a consumer
gets from a market basket…. i.e., utility is a device used to simplify
the ranking of market baskets.
Utility Function
A utility function = a formula that assigns a level of utility to each
market basket. Eg.
If the utility function for food (F) and clothing (C) is U(F,C) = F + 2C,
calculate utility for market basket (i) 8 units of food, 3 units of
clothing and (ii) 6 units of food and 4 units of clothing and (iii) 4
units of food and 4 units of clothing. Also comment on the
findings.
 Utility Functions and Indifference Curves (Contd.)
Ans.
(i) U(8,3) = 8 + 2*3 = 14
(ii) U(6,4) = 6 + 2*4 = 14
(iii) U(4,4) = 4 + 2*4 = 12
Baskets (i) and (ii) are on same utility curve and they are preferred
over (iii)

Let another utility function be U(F,C) = FC… then all the isoutility
curves would be such that their product would be equal to the
value of FC…
Suppose U(F,C) = 25… then some of the market baskets on this
indifference curve would be (5,5), (10,2.5), (2.5,10) and so on…
Another indifference curve could be at U(F,C) = 50 or U(F,C) =100.
How will the indifference map look like?
 Utility Functions and Indifference Curves (Contd.)
Ans.

Cardinal Utility Function =

Utility function describing by how much one market basket is
preferred to another.
 Utility Functions and Indifference Curves (Contd.)
However, in real world we have no way of telling whether a person
gets twice as much satisfaction from one market basket as from
another….
Nor do we know whether one person gets twice as much satisfaction
as another from consuming the same basket.

Hence, for understanding consumer behavior Ordinal rather than

Cardinal Utility Function is considered.

Ordinal Utility Function = Utility function that generates a ranking of

market baskets in order of most to least preferred.
It does not indicate by how much one is preferred to another.
 Budget Constraints
Budget Constraints =
Constraints that consumers face as a result of limited incomes.
Budget Line
All combinations of goods for which the total amount of money
spent is equal to income.
Consider that you have a fixed amount of income, I, that can be spent
on food and clothing.
Let F = amount of food purchased and C = amount of clothing. Let the
prices of the two goods be PF and PC., then
PFF = amount of money spent on food and
PCC = amount of money spent on clothing such that
PF F + PCC = I (ignoring savings)
If price of food = $1 per unit and price of clothing is $2 per unit and
the weekly income is $80 then the Budget line becomes
F + 2C = 80… How will the graph look like?
 Budget Constraints (contd.)

The slope of the budget line (measured between points B and D) is

−PF/PC = −10/20 = −1/2
 Effects of Changes in Income and Prices
Effects of a change in Income on the Budget Line

A change in income (with prices unchanged) causes the budget line

to shift parallel to the original line (L1).
 Effects of Changes in Income and Prices
Effects of a change in Price (of one good) on the Budget Line

A change in the price of one good (with income unchanged) causes

the budget line to rotate about one intercept.
 SM 300

Engineering Economics
 Consumer Choice
Given preferences and budget constraints, and assuming that consumers
make this choice in a rational way-- that they choose goods to maximize
the satisfaction they can achieve, given the limited budget available to
them, the maximizing market basket must satisfy two conditions:
1) It must be located on the budget line
2) It must give the consumer the most preferred combination of goods
and services.

Maximum satisfaction by choosing market basket A.

At this point, the budget line and indifference curve U2
are tangent, and no higher level of satisfaction (e.g.,
market basket D) can be attained.
 Consumer Choice (Contd.)
Thus,
The basket which maximizes satisfaction must lie on the highest
indifference curve that touches the budget line.
Point A is the point of tangency between indifference curve U2 and
the budget line.
At A, slope of the budget line = slope of the indifference curve.
For the indifference curve, at point A, the slope of the tangent can be
defined as, ∆C/∆F = negative of MRS i.e. – MRS
i.e. MRS = - ∆C/∆F
For the budget line, at point A the slope can be defined as,
Y-intercept/ X-intercept = - (I/PC) / (I/PF) = - PF/PC = ∆C/∆F
Therefore, we can say that satisfaction is maximized (given the
budget constraint) at the point where
MRS = - ( ∆C/∆F ) = - (- PF/PC ) = PF/PC i.e.
MRS = PF/PC
 Total Utility vs Marginal Utility
Total Utility (TU) = The amount of satisfaction received from all the
units of a good or service consumed.
Marginal Utility (MU) = The additional satisfaction obtained from
consuming one additional unit of a good or service.
Law of Diminishing Marginal Utility
It states that the amount of extra or marginal utility declines as a
person consumes more and more of a good. Eg.
Marginal Utility and Consumer Choice (Contd.)
 Marginal Utility and Consumer Choice (Contd.)
One of the fundamental condition of maximizing satisfaction or
utility is the Equimarginal Principle:
It states that…. a consumer having fixed income and facing given
market prices of goods will achieve maximum satisfaction or utility
when the marginal utility of the last dollar spent on each good is
exactly the same as the marginal utility of the last dollar spent on
any other good.

Why must this condition hold?

If any good gave more marginal utility per dollar, the consumer
would increase his/her utility by taking money away from other
goods and spending more on that good until….
the law of diminishing marginal utility will drive its marginal utility
per dollar down to equality with that of other goods. Similarly,
If any good gave less marginal utility, he/she would buy less…until the
marginal utility of the last dollar spent rises back to common level.
 Marginal Utility and Consumer Choice (Contd.)
Utility Maximizing Rule of Consumer Equilibrium: A condition in
which total utility cannot increase by spending more of a given
budget on one good and spending less on another good.
Restating algebraically,
 SM 300

Engineering Economics
 Demand
Demand is a curve or schedule showing the various quantities of a
product consumers are willing to purchase at possible prices
during a specified period of time, ceteris paribus (a Latin phrase
meaning "with other things the same" or "all other things being
equal or held constant“) Eg.

The above demand schedule and curve shows how many DVDs an
individual consumer is willing to purchase at different possible
prices.
 Demand Function Using Regression Analysis
Example: The following data is collected about the number of pizzas
that are sold when a pizzeria experiments with different prices:
Scatter-Plot for Pizza
Price Pizzas Sold
20
$7 16
$8 14
Price 15

$9 13 10
$10 10
5
$11 10
0
$12 7
0 5 10 15 20
$13 8 Quantity
$14 5
Using this data can you find approximately
$15 3
how many pizzas can be sold at $11.5?
 Demand Function Using Regression Analysis (Contd.)
Consider quantity of Pizza Q to be a function of Price P i.e Q = f(P)
The function could be a linear regression line of the form
Q=a+bP
[Note: While drawing demand curve Q will usually be on x-axis]
where Q = Quantity demanded, P = Price, a = intercept and b =
coefficient of P (= slope of the regression line)
Using Ordinary Least Squares (OLS) Regression Formula we can find
for a general equation such as y  a  bx

n xy   x  y and a   y  b x
b
n x 2  ( x ) 2 n
OR a  y  bx
Where
n= number of paired observations
 Demand Function Using Regression Analysis (Contd.)
In the Case of Pizza:
Price (X) Pizzas Sold (Y) XY X2 y  a  bx
7 16 112 49
8 14 112 64 n xy   x y
b
9 13 117 81 n x 2  ( x ) 2
10 10 100 100
11
12
10
7
110
84
121
144 a 

y b x 
13 8 104 169 n
14 5 70 196
15 3 45 225
99 86 854 1149

n=9 b = (9 * 854 -99 * 86)/ (9 * 1149 - 99 * 99) = -1.53333

a = (86 - (-1.5333) * 99)/9 = 26.422
i.e. Q = 26.422 – 1.533 P
Hence, at P = $11.5, the approx. Q = 26.422 – 1.533 * 11.5 = 8.79 or 9
 Law of Demand
The principle that there is an inverse relationship between the price
of a good and the quantity buyers are willing to purchase in a
defined time period, ceteris paribus. Why is this so?
Explanation 1: From Consumer Equilibrium to the Law of Demand
Eg. Suppose Bob goes to McDonald’s for lunch with $8 in his pocket to
spend for Big Macs ($2 price) and milkshakes ($2 price). Suppose Bob
reaches consumer equilibrium as follows:
Now suppose the price of a Big
Mac falls to $1 and upsets the
above equality. This changes the Bob gains more utility/$ by buying Big
formula to the following: Mac than milkshake. To restore max.
total utility, spends more on Big Macs.
The MU of a Big Mac must fall as he
buys more and the MU of a milkshake
must rise as Bob buys fewer… Thus, a
fall in the price of Big Macs  Bob buys
more Big Macs…The law of demand.
 Market Demand
• Individual demand curves differ for consumers. The market
demand curve = Curve relating the quantity of a good that all
consumers in a market will buy to its price.

2 Points:
(i) Market Demand curve
will shift to the RIGHT as
more consumers enter
the market.
(ii) Factors affecting
demands of many
consumers will also
affect market demand.
 Market Demand (Example)
Assuming Fred and Mary are the only buyers of DVDs in the market.
 Summary of Effects on Demand
(Source: Tucker, I. B., Microeconomics for Today, Cengage)
 SM 300

Engineering Economics
 Shift in Demand Curve
• The demand curve is downward sloping; holding other things
equal, consumers will want to purchase more of a good as its price
goes down  Movement on the demand curve
• However, the quantity demanded may also depend on other
variables or factors
• Such factors often shift the whole demand curve to either to the
right or to the left. Can you think of some such factors?

The diagram depicts shift in the

demand curve from D to D’
Effect of Various Non-Price Determinants of Demand
(Source: Tucker, I. B., Microeconomics for Today)
Effect of Various Non-Price Determinants of Demand
Effect of Various Non-Price Determinants of Demand
 Shift in Demand Curve (Contd.)
Substitute & Complementary Goods Affecting Demand
Substitute Goods: Two goods for
which an increase in the price of one
leads to an increase in the quantity
demanded of the other.
Eg. Petrol Cars and Diesel Cars

Complementary Goods: Two goods

for which an increase in the price of
one leads to a decrease in the quantity
demanded of the other.
Eg. Petrol and Petrol Car
 Law of Demand- Explanation 2
Explanation 2: Due to Substitution and Income Effects
Substitution Effect: The change in quantity demanded of a good or service
caused by a change in its price relative to substitutes.
Income Effect: The change in quantity demanded of a good or service
caused by a change in real income (purchasing power).
The substitution effect F1E (associated with a move
from A to D) changes the relative prices of food and
clothing but keeps real income (satisfaction) constant.
The income effect EF2 (associated with a
move from D to B) keeps relative prices
constant but increases purchasing power.
Thus, decrease in price of food
leads to increase in the food
quantity consumed.
Note: The substitution and
income effect take place
Effect of decrease in price of food simultaneously.
 Normal, Inferior and Giffen Goods
Normal Good: A good for which income effect and substitution effect are
both positive  has downward sloping demand curve. Eg. Food in the
earlier graph is a normal good because the income effect EF2 and
substitution effect F1E are positive.
Inferior Good: A good that has a negative income effect but large positive
substitution effect  downward sloping demand curve
Giffen Good: Good whose demand curve slopes upward because the
(negative) income effect is larger than the (positive) substitution effect.

Effect of Decrease in
price in Inferior Food
 Normal, Inferior and Giffen Goods (Contd.)
Giffen Good- Inferior Quality Staple Food of Poor
Sir Robert Giffen (1837-1910), an eminent economist,
observed that the consumption of bread increased as its
price increased.
The argument was that bread was a staple food for low income
consumers... A rise in its price would not deter people from buying as much
as before… Effect of Decrease
But “poor” people would in price of Giffen
now have so little extra food
money to spend on meat or
other luxury foods that they
would abandon their
demand for these and
instead buy more bread to fill
up their stomachs…
Thus, Rise (Fall) in price of bread  Increase (Decrease) in Demand
for bread
Normal, Inferior and Giffen Goods (Contd.)

Example

Normal
Rice

Relatively
Inferior
quality
rice
Inferior
quality
staple
food for
poor.
 SM 300

Engineering Economics
 Supply
• Supply Curve: It depicts the relationship between the quantity of
a good that producers are willing to sell and the price of the good
Other than price, factors that
can affect Supply Curve i.e.
Shift Supply Curve towards
right include

 Reduction in costs of raw

materials
 Reduction in expenses
towards labor
 Reduction in interest rates
for capital

The supply curve is upward sloping: Similar to Demand Function,

The higher the price, the more firms are one can use regression analysis
able and willing to produce and sell. to get a Supply Function.
Summary of Effects on Supply
Effect of Various Non-Price Determinants of Supply
Effect of Various Non-Price Determinants of Supply

Inverse
Effect of Various Non-Price Determinants of Supply
 Market Equilibrium
• Equilibrium (or market clearing) price: Price that equates the
quantity supplied to the quantity demanded.
• Market mechanism: Tendency in a free market for price to change
until the market clears.
• Surplus: Situation in which the quantity supplied exceeds the
quantity demanded.
• Shortage: Situation in which the quantity demanded exceeds the
quantity supplied
The market clears at price P0
and quantity Q0.

At the higher price P1, a

surplus develops, so price falls.

At the lower price P2, there is a

shortage, so price is bid up.
Changes in Market Equilibrium

Given the Demand function

and Supply function,
the point of intersection of
the two functions will give the
Market Equilibrium Price and
Quantity.
 SM 300

Engineering Economics
 Market Efficiency- Consumer Surplus
Consumer Surplus = Difference between what a consumer is willing
to pay for a good and the amount actually paid.

For the market as a whole, consumer

surplus = the area under the demand
curve and above the line representing the
market price of the good.

Here, the consumer

surplus is given by the
yellow-shaded triangle and
is =
1/2 * ($20 - $14) * 6500 =
$19,500.
 Market Efficiency- Producer Surplus

Producer Surplus = The value of the difference between the actual

selling price of a product and the price producers are willing to
sell it for on the supply curve.
 Market Efficiency and Deadweight Loss
Deadweight Loss = The net loss of consumer and producer surplus for
underproduction or overproduction of a product.

• The total net benefit, or total surplus = the entire triangle consisting of the
consumer and producer surplus triangles.
• Underproduction leads to market inefficiency because the deadweight loss
(gray triangle ABE) is no longer earned by either consumers or producers.
• Overproduction leads to market inefficiency because too many resources
are devoted to this product and a deadweight loss of area EDC occurs.
 Diamond-Water Paradox Revisited

• (a) shows the marginal utility per carat you receive from each diamond
consumed, and (b) represents marginal utility per gallon of water
consumed….. The vertical line, S, in each graph is the supply of
diamonds or water available per year.
As per Law of Diminishing Marginal Utility…
Since water is much more plentiful than diamonds, the supply for water
intersects the marginal utility curve at MUw ~= zero…Conversely,
the supply for diamonds intersects the marginal utility curve at a much
higher marginal utility, MUd.
 Diamond-Water Paradox Revisited (Contd.)

Now, for consumer equilibrium… MUw / Pw = MUd / Pd

i.e. MUw/MUd = Pw/Pd
Because of the relative marginal utilities of water and diamonds, you
are willing to pay much more for one more carat of a diamond
than for one more gallon of water.
 SM 300

Engineering Economics
 (Own) Price Elasticity of Demand
Price Elasticity of Demand = The ratio of the % change in the
quantity demanded of a product to a % change in its price OR
% change in quantity demanded of a good resulting from a 1%
increase in its price Point elasticity of demand = Price
elasticity at a particular point on the
demand curve….
Price elasticity of demand can also be
written as: Ed =
where
∆Q / ∆P = Slope of Demand at point (P, Q)

Arc elasticity of demand = Price elasticity

calculated over a range of prices.
Ed value is negative for Normal Goods since
quantity change is opposite of price change.
 (Own) Price Elasticity of Demand
Why Arc Elasticity of Demand Formula?

Consider 2 points on a demand curve:

Point 1 : P = 4 and Q = 20
Point 2: P = 10 and Q = 2
Calculate Point Price Elasticity of Demand and Arc
Elasticity of Demand when change is from Point 1 to
Point 2
Calculate Point Price Elasticity of Demand and Arc
Elasticity of Demand when change is from Point 2 to
Point 1.
(Own) Price Elasticity Ranges-- Normal and Giffen Goods
 Numerical Example
Yesterday, the price of envelopes was $3 a box, and I was willing to
buy 10 boxes. Today, the price has gone up to $3.75 a box, and I
am now willing to buy 8 boxes. Is my demand for envelopes
elastic or inelastic? What is my elasticity of demand? [Use point
elasticity formula]
Ans:
% Change in Quantity = (8 - 10)/(10) = -0.20 = -20%
% Change in Price = (3.75 - 3.00)/(3.00) = 0.25 = 25%
Elasticity = |(-20%)/(25%)| = |-0.8| = 0.8
The elasticity of demand is inelastic, since it between 0 and 1.

What would be the Own Price Elasticity of Demand on the Demand

Curve at different points?
 More on Own-Price Elasticity… (Contd.)
Note that Price Elasticity of Demand not only depends on the slope
of the demand curve but also on the Price and Quantity
The elasticity, therefore, varies along the curve as price and quantity
change…. Slope is constant for linear demand curve….
Near the top, because price is high and quantity is small, the
elasticity is large in magnitude….. The elasticity becomes smaller
as we move down the curve.
 SM 300

Engineering Economics
 More on Own-Price Elasticity… (Contd.)
• How would be the Demand Curves that are Perfectly Elastic,
Perfectly Inelastic and Unitary Elasticity?
• What about price elasticity of demand for two parallel demand
lines? Same or Different?

• How will a demand curve

with unit elasticity at all
points look like?

Unit Elasticity would imply that

at every point
% Change in Quantity = %
Change in Price
It is a
OR
Rectangular
At every point
Hyperbola
dQ * P = dP * Q
Curve
 Cross Price Elasticity of Demand
Cross Price Elasticity of Demand = The rate of response of quantity
demanded of one good, due to a price change of another good.

Point Formula Arc Formula

 Cross Price Elasticity of Demand…. Some Examples
Eg. Petrol Price and Demand for Petrol Cars = Complements
Apple Juice Price and Demand for Orange Juice = Substitutes

Cross Price Elasticity of Demand… Analysis Diagrams

 Ranges for Cross Price Elasticity of Demand

Note--- There
are Shifts in
the Demand
Curve
 Price Elasticity of Supply
The responsiveness, or elasticity, of the quantity supplied
of a good or service to a change in its price or cost
 Price Elasticity of Supply

Can PEoS be Negative? How does a Perfectly Elastic Supply

Curve and Perfectly Inelastic Supply Curve look like? Any
Examples?
 Elasticity of Supply- Example
Below are the supply schedules for natural rubber and man-made
rubber.

1. Calculate the price elasticity of supply for natural rubber and man-
made rubber. [Use Arc Elasticity of Supply Formula]
2. Comment on their values and suggest reasons why they differ.
 Elasticity of Supply- Example… Solution
1.
For Natural Rubber & Man-Made Rubber:
%Change in Price = (1.00-0.80)/[(1.00+0.80)/2] = 22.222%
For Natural Rubber:
% Change in Quantity = (1100-1000)/[(1100+1000)/2] = 9.524%
For Man-Made Rubber:
% Change in Quantity = (2800-2000)/[(2800+2000)/2] = 33.333%

Price Elasticity of Supply:

Natural Rubber = 9.524/22.222 = 0.4286
Man-Made Rubber = 33.333/22.222 = 1.5

2. Elasticity of Supply of Natural Rubber is < Elasticity of Supply of Man-Made

Rubber
Natural Rubber is made from the extract of Rubber Tree while Man-made Rubber
uses raw material derived from Petroleum (which may be more easily
available)
 Income Elasticity
Income Elasticity = The measure of how responsive is the demand to
changes in income, when other factors are held constant.
Income Elasticity of a good of service is given by:

Point Formula-

Arc Formula-
 SM 300

Engineering Economics
 Elasticity at a Point for a Given Curve [Calculus]
In general, if Demand is given by a function: Q = D(p)
Notice that here the quantity demanded of the good is being written as a function
of the price.
The derivative of quantity demanded with respect to the good's price will be
written dQ/dP = D’(p).
Then the own-price elasticity of demand is given by:
 = D’(p) * [p/D(p)]
(Eg. from Source: Petersen et. al., Managerial Economics)
The demand for handkerchiefs produced by a Daman manufacturer has
been estimated to be P = 30 – Q/200
a) Compute the point elasticity at P = Rs. 10 and P = Rs. 15
b) How does the point elasticity vary with increase in price from Rs. 10 to
Rs. 15?
Ans. (a) Q = -200P + 6000 Therefore D’(P) = -200
At P = 10 Point elasticity = D’(P) * [P/D(P)] = (-200) * [10/ (-200 * 10 +6000)]
= -0.5 and at P = 15 Point Elasticity = -1
(b) As price rises the demand becomes more elastic.
 Elasticity at a Point for a Given Curve [Calculus] (contd.)
Suppose Demand Function for a particular product X is given by
QX= a0 + a1PX + a2N + a3I + a4PY where
PX = Price of commodity X
N = Number of Consumers in the Market
I = Consumer Income
PY = Prices of related commodities (Complements or Substitutes)
Then, another Specific Version of Point Price Elasticity of Demand
Formula is defined in terms of the price slope coefficient (a1 =
ΔQ/ΔP) of the above linear demand equation-
Price Elasticity of Demand at a specific point (P1,Q1) = a1 * P1/Q1
Where a1 = above slope coefficient
P1 = Price and
Q1 = Quantity at P1
 Example Problem
(Source: Salvatore Dominick, Managerial Economics In a Global Economy, Seventh Edition)

Gary operates an automobile detailing business. An automobile

detailer restores a car to the level of cleanliness and perfection
that it had when it was new. His fastidious nature, attention to
detail, and ability to effectively manage employees have helped
to make his business profitable, but he believes that more
information about the market would allow him to operate more
efficiently. He uses regression analysis to estimate the demand
function for his business and gets the following result:
QX = 235 - 3PX + 40A - 20U + 8PW
The number of detailing jobs he gets per month (QX) depends on
the price he charges per job (PX), his monthly advertising
expenditures (A) measured in $1,000s, the regional percentage
unemployment rate (U), and the average price charged by local
car wash businesses (PW) for a standard wash and wax.
 Example Problem (Solution)
1. Is a wash and wax at the local car wash a complement or a
substitute for automobile detailing? How can you tell?
Ans. A wash and wax at the local car wash is a substitute for
detailing.
When two goods are substitutes, the demand for one good
increases when the price of other good increases. In this case,
the slope coefficient associated with the variable PW (the price
of a wash and wax at the local car wash) is positive, which
means that the goods are substitutes.
2. Gary is currently charging $65 per detailing job and spending
$3,500 per month on advertising. The regional unemployment
rate is 7.5% and the average price of a wash and wax at a local
car wash is $15. How many detailing jobs per month can Gary
expect under these conditions?
Ans. QX = 235 - 3PX + 40A - 20U + 8PW
QX = 235 - (3)(65) + (40)(3.5) - (20)(7.5) + (8)(15) = 150
 Example Problem (Contd.)
3. Calculate the point price elasticity of demand under current
conditions. Is it elastic or inelastic?
Ans. EP= -3(65/150) = -1.3 which means Elastic demand

4. Assume that Gary increases his advertising expenditures to

$4,500 and raises his price to $70 and that all other conditions
remain unchanged. Calculate the point price elasticity of
demand.
Ans. QX = 235 - (3)(70) + (40)(4.5) - (20)(7.5) + (8)(15) = 175
EP = -3(70/175) = -1.2
 Elasticity and Tax Incidence
Source: https://opentextbc.ca/principlesofeconomics/chapter/5-3-elasticity-and-pricing/
• The analysis, or manner, of how the burden of a tax is divided between
consumers and producers is called tax incidence.
• Since a tax can be viewed as raising the costs of production, this could
also be represented by a leftward shift of the supply curve, where the
new supply curve would intersect the demand at the new quantity Qt.
• An excise tax introduces a wedge between
the price paid by consumers (Pc) and the
price received by producers (Pp).
• When the demand is more elastic than
supply, the tax incidence on consumers Pc –
Pe is lower than the tax incidence on
producers Pe – Pp.
• Of the total price paid by consumers, part is
retained by the sellers and part is paid to the
government in the form of a tax.
• Here, the tax burden falls disproportionately on the sellers, and a larger
proportion of the tax revenue (the shaded area) is due to the resulting
lower price received by the sellers than by the resulting higher prices
paid by the buyers.
 Elasticity and Tax Incidence (Contd.)
b) When the supply is more elastic than demand, the tax incidence on
consumers Pc – Pe is larger than the tax incidence on producers Pe – Pp.
• When the demand is inelastic, consumers are
not very responsive to price changes, and the
quantity demanded remains relatively
constant when the tax is introduced.
• Eg. In the case of smoking, the demand is
inelastic because consumers are addicted to
the product.
• The government can then pass the tax
burden along to consumers in the form of
higher prices, without much of a decline in
the equilibrium quantity.
• Thus, if demand is more inelastic than supply, consumers bear
most of the tax burden, and if supply is more inelastic than
demand, sellers bear most of the tax burden.
• Note that in a market where both the demand and supply are very
elastic, the imposition of an excise tax generates low revenue.
 SM 300

Engineering Economics
Economic Growth and
Development
 Economic Growth
Economic Growth = An increase in the total output of a
nation over time…
Economic growth is usually measured as the annual rate of
increase in a nation’s Real (i.e. inflation/deflation adjusted)
Gross Domestic Product (GDP)
Nominal Gross Domestic Product (GDP) = The value, at
current market prices, of the total final output produced
inside a country during a given year.
Real GDP = Nominal GDP corrected for inflation, i.e. real
GDP = Nominal GDP divided by the GDP deflator.
In India:
Central Statistical Office (CSO) is responsible for compilation of
National Accounts including Estimates of National Income (i.e. GDP),
conduct of Annual Survey of Industries, Consumer Price Indexes,
Economic Census, and Compilation of Index of Industrial Production.
 GDP Calculation Methods
1. Expenditure (or Demand) approach
Here, the components of GDP include personal consumption
expenditures (C), business investments (I), government spending (G),
exports (X), and imports (M)
GDP = C + I + G + (X - M)

2. Production (or Supply or Value Added or Output)

approach

For each industry, this involves first determining its output and then
subtracting the goods and services that were used up in the process
of generating that output. Thus, the difference between an industry’s
output and its intermediate consumption is its gross value added.
GDP = Value of output – Intermediate consumption at
factor cost
 GDP Calculation Methods
3. Income approach
• Here, GDP is the sum of the incomes earned through the
production of goods and services
• It is defined as:

GDP = Compensation to employees + gross operating surplus +

gross mixed income + taxes on production and imports − Subsidies
on production

Where,
Compensation to employees = Total remuneration to employees for
work done (includes wages and salaries and employer contributions)
Gross operating surplus = Surplus due to owners of incorporated
businesses (often called profits)
Gross mixed income = Surplus for unincorporated businesses (mostly
small businesses)
 GDP Calculation In India
(Source: http://www.mospi.gov.in/133-gross-domestic-product)
Brief Method of compiling GDP estimates by Industry
• Divide the whole economy into various sectors comprising
primary, secondary and tertiary activities.
• The estimates of GDP in respect of agriculture, forestry and
logging, fishing, mining and quarrying, registered manufacturing
(establishments registered under Factories Act, 1948) and
construction are based on production approach.
• Income approach is used in the estimation of GDP originating in
Un-registered manufacturing (establishments not registered under
Factories Act), electricity, gas and water supply, trade, hotels and
restaurants, transport, storage, communication, banking and
insurance, real estate, ownership of dwellings, business services,
public administration and defence and other services.
 Economic Growth (contd.)
(Source: World Bank) Economic growth comes intwo forms:
i)an economy can either grow "extensively" by using more resources
(such as physical, human, or natural capital) or
ii)"intensively" by using the same amount of resources more
efficiently (productively).

Economic growth, by increasing a nation's total wealth, also

enhances its potential for reducing poverty and solving other social
problems.
Yet historically economic growth was not followed by similar progress
in human development….
Instead growth was achieved at the cost of greater inequality, higher
unemployment, weakened democracy, loss of cultural identity, or
overconsumption of natural resources needed by future generations.
 Economic Growth and Economic Development
Economic Development (as defined by World Bank):
Qualitative change and restructuring in a country's economy in
connection with technological and social progress.
The main indicator of Economic Development is increasing Gross
National Product (GNP) per Capita or increasing Gross Domestic
Product (GDP) per Capita [Per Capita  Divide The Measure by Population]

GNP = The value of all final goods and services produced in a country
in one year (gross domestic product) + income that residents have
received from abroad – income claimed by non-residents.

When will GNP < GDP and When Will GNP > GDP?
GNP << GDP if much of the income from a country's production flows to
foreign persons or firms.
GNP >> GDP if the people or firms of a country hold large amounts of the
stocks and bonds of firms or governments of other countries, and receive
income from them.
Economic Growth and Economic Development (Contd.)
Another term that is used in the context of economic growth of
countries is Gross National Income (GNI).

Note that gross national income (GNI) is identical to gross national

product (GNP) as previously used in national accounts generally.
Definition by Organisation for Economic Co-operation and
Development (OECD):

Gross national income (GNI) = GDP less net taxes on production and
imports, less compensation of employees and property income
payable to the rest of the world plus the corresponding items
receivable from the rest of the world.

In other words, GDP less primary incomes payable to non- resident

units plus primary incomes receivable from non-resident units.

Therefore, GNP per capita ~ Income per capita or GNI per capita
 Economic Growth and Development
When economic growth (i.e. growth in GDP) is achieved by using
more labour, it may not result in economic development (i.e. per
capita income growth)
But when economic growth is achieved through more productive use
of all resources, including labour, it results in higher per capita
income and improvement in people's average standard of living
(material well-being).
Quality of Life (as defined by World Bank): People's overall well-
being.
Quality of life is difficult to measure (whether for an individual,
group, or nation) because in addition to material well-being (i.e.
standard of living) it includes such intangible components as the
quality of the environment, national security, personal safety, and
political and economic freedoms.
Economic Growth and Human Development
 SM 300

Engineering Economics
 Human Development Index
Human Development Index (HDI):
A composite of several social indicators that is useful for broad cross-
country comparisons even though it yields little specific
information about each country. First used in the United Nations
Development Programme's Human Development Report 1990.
HDI is a summary index, designed to reflect average achievements in
three basic aspects of human development …

(Source: http://hdr.undp.org/sites/default/files/hdr2020_technical_notes.pdf)
 Human Development Index (contd.)
What does HDI tell us?
• Emphasizes people and their capabilities as ultimate criteria for
assessing the development of a country, not economic growth
alone.
• Can also be used to question national policy choices, …
How 2 countries with the same level of GNI per capita have different
human development outcomes or a country with higher GNI per
capita has lower human development outcomes.
Eg. In 2019, United Arab Emirates’ GNI per capita (66,912) > Japan’s
GNI per capita (40,799) but…
Life expectancy at birth is 77.8 as compared to 84.5 in Japan and
both mean years of schooling and expected years of schooling is
lesser than those prevailing in Japan
Japan has a much higher HDI value than UAE…..
These contrasts can stimulate debate about government policy
priorities.
 Human Development Index (contd.)
Steps in Human Development Index (HDI) Calculation:
Step 1. Creating the dimension indices-
• Minimum and maximum values (goalposts) are set in order to transform
the indicators expressed in different units into indices between 0 and 1.
• These goalposts act as the ‘natural zeroes’ and ‘aspirational goals’,
respectively, from which component indicators are standardized.
For 2020 HDI they are:
 Human Development Index (contd.)
Step 1. Creating the dimension indices (Contd.)-
• For Health dimension, Life Expectancy (years) is used where,
Life expectancy at birth: Number of years a new-born infant could expect
to live if prevailing patterns of age-specific mortality rates at the time of
birth stay the same throughout the infant’s life.
• For the education dimension, index is first applied to each of
the two indicators, and then the arithmetic mean of the two
resulting indices is taken. Here,
Mean Years of Schooling [for adult population] = Average number of
years of education received by people ages 25 and older,
converted from education attainment levels using official
durations of each level
Expected years of schooling [for children of school-entrance age] =
Number of years of schooling that a child of school entrance age
can expect to receive if prevailing patterns of age-specific
enrolment rates persist throughout the child’s life.
 Human Development Index (contd.)
Step 1. Creating the dimension indices (Contd.)-
For Income dimension
• It is believed that each additional dollar of income has a smaller
effect on expanding capabilities…. Hence, for income, the natural
logarithm of the actual, minimum and maximum values is used.
• Further, Income (i.e. GNI) is represented in Purchasing Power
Parity terms
Market Exchange Rate & Purchasing Power Parity (PPP) exchange
Rate
Market Exchange Rate: Balances the demand and supply for
international currencies…. They are the basis for international
trade.
Eg. If a company wants to import a equipment from US that has a
price of US$ 10,000 and the market exchange rate is US$1 = Rs. 61,
then the cost of the equipment in Rupee terms will be Rs. 61 *
10,000 = Rs. 610,000
 Human Development Index (contd.)
Purchasing Power Parity (PPP) exchange rates capture the
differences between the cost of a given bundle of goods and
services in different countries.
= The rate at which the currency of one country would have to be
converted into that of another country to buy the same amount of
goods and services in each country.
Typically, a PPP for a country is expressed in terms of the currency of a base
country, with the US dollar commonly being used.
Used as deflators, they enable cross-country comparisons of GDP and its
expenditure components.
(Reading Source: International Monetary Fund or IMF, “PPP Versus the Market: Which
Weight Matters? https://www.imf.org/external/pubs/ft/fandd/2007/03/basics.htm)
Eg: If a burger is selling in London for £2 and in New York for $4, this would
imply a PPP exchange rate of 1 pound to 2 U.S. dollars.
This PPP exchange rate may be different from that prevailing in financial
markets (so that the actual dollar cost of a burger in London may be
either more or less than the $4 it sells for in New York).
 Human Development Index (contd.)
To facilitate price comparisons across countries, the International
Comparisons Program (ICP) was established by the United Nations
and the University of Pennsylvania in 1968.
Under the authority of the United Nations Statistical Commission,
the 2011 round of ICP covered 199 economies…. The ICP 2011
provides estimates of real expenditure on GDP and its major
aggregates for 177 countries.
The ICP divides GDP aggregates into 155 categories (referred to as
“basic headings”).
Prices were collected during 2011 for individual products within each
basic heading to compute national annual average prices for each
product for 2011.
These products cover all aspects of each country’s expenditure on
GDP, ranging from food, clothing and footwear to hospital
equipment and compensation of government employees, etc.
 Human Development Index (contd.)
Step 2. Aggregating the dimensional indices to produce the Human
Development Index
The HDI is the geometric mean of the three dimensional indices:
HDI = (IHealth . IEducation . IIncome) 1/3

Eg…. Sudan
Human Development Index (contd.)
 Human Development Index (contd.)
HDI Index and Its Components for Select Countries
 Sustainable Development
According to the United Nations World Commission on
Environment and Development (1987), sustainable
development is "development that meets the needs of the
present without compromising the ability of future
generations to meet their own needs.“

World Bank Definition: "a process of managing a portfolio

of assets to preserve and enhance the opportunities people
face."

Sustainable development includes economic,

environmental, and social sustainability, which can be
achieved by rationally managing physical, natural, and
human capital.
 SM 300

Engineering Economics
Cost Concepts
 THE VARIOUS MEASURES OF COST
•Manufacturing Costs- In converting raw materials into
finished goods, a manufacturer incurs various costs
associated with operating a factory. Divided into-
Direct materials- Eg. Steel in bridge construction
Direct labor- Eg. Labor cost of assembly-line workers
Manufacturing Overhead- Eg. Maintenance & repairs on
production equipment; Overtime premiums

•Non-manufacturing Costs- Additional costs incurred in

supporting any manufacturing operation. Divided into-
Non-Manufacturing Overhead- Eg. Heat and light
Marketing- Eg. Advertising; Sales travel; Sales commission
Administrative- Eg. Public relations
 Some More Cost Concepts (Contd.)
Direct, Indirect, and Standard Costs
Direct Costs: Costs that can be reasonably measured and
allocated to specific output or work activity. Eg.
• Labour and Material costs directly associated with
production/service delivery
Indirect Costs: Costs that are difficult to attribute or allocate
to a specific output or work activity. Sometimes may also be
called as overhead cost or burden cost. Eg.
• General Repair costs, Costs of common tools and other
general supplies
Standard Costs: Planned costs per unit of output that are
established in advance of actual production or service
delivery. They are developed from anticipated direct labour
hours, materials, and overhead categories.
 Some More Cost Concepts (Contd.)
Cash Cost VS Book Cost
Cash Cost: A cost that involves payment of cash.
• This results in a cash flow.
• It is often the future expenses incurred for the
alternatives being analysed from the perspective
established for the analysis.
• In Engineering Economics, only those costs that are cash
flows or potential cash flows need to be considered for
the analysis
Book Cost: A cost that involves non-cash transactions. Eg.
• Depreciation charged for the use of assets like plant and
machinery
• Although, not a cash flow, it is important when it affects
other cash flows like income tax.
 Some More Cost Concepts (Contd.)
Sunk Cost
Definition: Cost that has already been incurred in the past
and has no relevance to estimates of future costs and
revenues related to an alternative course of action.
• Sunk cost is common to all alternatives, is not part of the
future (prospective) cash flows, and can be disregarded in
an engineering economic analysis. Eg.
• While deciding the selling price for an old car, the cost of
repair service two years back is a sunk cost.
 Some More Cost Concepts (Contd.)
Opportunity Cost
Definition: It is the cost of the best rejected (i.e. foregone)
opportunity and is often hidden or implied.
• Opportunity cost is incurred because people face
tradeoffs and hence making decisions requires
comparing the costs and benefits of alternative courses
of action.
What is the opportunity cost of studying in school/college?
…. Maybe a job!
Opportunity cost of going to
School/College = Fees paid + Salary
earned from the job
 Some More Cost Concepts
•Costs of production may be divided into fixed costs
and variable costs.
•Fixed costs are those costs that do not vary with
the quantity of output produced. Eg.
Rent for Land/Building, Salaries to Employees, Investments
on machinery
•Variable costs are those costs that vary with the
quantity of output produced. Eg.
Raw material costs, Electricity charges to run machinery
•Total Costs (TC) is the sum total of fixed and
variable costs
Total Costs = Total Fixed Costs + Total Variable Costs
TC = TFC + TVC
 Some More Cost Concepts (Contd.)
•Average Costs
–Average costs can be determined by dividing the firm’s
costs by the quantity of output it produces.
–The average cost is the cost of each typical unit of
product.

Average Total Costs (ATC)

= Total Cost / Number of Units
= (Fixed Costs + Variable Costs) / Number of Units
= Average Fixed Costs (AFC) + Average Variable Costs (AVC)
 Marginal Cost
The change in total production cost due to
making or production of one additional unit.

(change in total cost) TC

MC  
(change in quantity) Q
Example: The Various Measures of Cost: Thirsty Thelma’s
Lemonade Stand (Source: Mankiw)

Copyright©2004 South-Western
Figure Thirsty Thelma’s Total-Cost Curves

Total Cost
$15.00 Total-cost curve
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Copyright © 2004 South-Western
Figure Thirsty Thelma’s Average-Cost and Marginal-Cost Curves

Costs
$3.50
3.25
3.00
2.75
2.50
2.25 MC
2.00
1.75
1.50 ATC

1.25 AVC
1.00
0.75
0.50
AFC
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Copyright © 2004 South-Western